Income tax, National Insurance and VAT

I was rather surprised that last week’s fuss about employers’ National Insurance Contributions didn’t lead on to a debate about the taxes most voters pay. That has been such a big issue in previous elections I kept on expecting it to start up, but it didn’t happen.

It’s even more surprising because it is a story that leads in unexpected directions. Workers face three main taxes: Income Tax, National Insurance Contributions and Value Added Tax. In this tax year, they will account for a bit over 63% of all taxes and Contributions.

As we all know, the Thatcher revolution saw a big cut in the rates of income tax. Famously, the rates paid by the richest were cut, but so too was the basic rate that most workers pay.

What is less often remembered is that the other two elements of the tax trinity were increased to compensate. The standard rate of VAT was almost doubled overnight and the rate at which National Insurance Contributions are levied on most workers was raised in stages till it was 53% higher than it had been when Mrs Thatcher was elected.

The table below compares the tax rates inherited by Mrs Thatcher in 1979, Tony Blair in 1997 and today:

Tax year

Employee NICs main rate

Income tax basic rate

VAT standard rate

1978 to 79

6.5

33.0

8.0

1997 to 98

10.0

23.0

17.5

2010 to 11

11.0

20.0

17.5

The table simplifies matters because the structure of each of these taxes has changed over 30 years. Fortunately that doesn’t affect the point I’m trying to make here, which is that the reduction in the rate of income tax faced by most workers has been accompanied by an increase in the main rate of employee NI Contributions and the standard rate of Value Added Tax.

This is a shift that tends to make the tax system less progressive, as can be seen using data from the Office for National Statistics.

In the three tables that follow I have divided non-retired households into fifths ranked by their income (quintiles) and look at the proportion of their income taken by these taxes in 2007/8. (This is the most recent year we have data for; I have looked at non-retired households because retired people are less likely to pay income tax and National Insurance Contributions.)

The first table shows the percentage of gross income paid in income tax by non-retired households in different quintile groups in 2007/8. We can see that the richer a quintile, the higher the proportion of their income that group will pay, on average – because of this income tax is a progressive tax.

Bottom

2nd

3rd

4th

Top

All non-retiredhouseholds

4.4

9.3

12.3

14.7

18.8

14.5

This makes sense, people with very low incomes pay no income tax and those with higher incomes pay at a higher rate; even in the middle of the distribution, the lower your income, the high the proportion of it that will be taken by your tax free allowance.

The second table looks at employee NI Contributions tax as a percentage of gross income for non-retired households by quintile groups.

Bottom

2nd

3rd

4th

Top

All non-retiredhouseholds

2.6

4.9

5.9

6.2

4.7

5.2

For the bottom 80% of the income distribution, employees’ National Insurance Contributions are also progressive (though not as progressive as income tax – the ratio between the bottom quintile and the fourth is smaller.) But the structure of National Insurance Contributions – there is an Upper Earnings Limit, above which a lower rate is charged – means that the richest quintile pay a smaller proportion of their income than any other quintile except the bottom.

Value Added Tax is a very different proposition. Although rich people tend to spend more than poor people, there is a certain amount of spending that is unavoidable, so the poorest groups pay a much higher proportion of their income in VAT than richer groups. VAT is a regressive tax, as shown by the third of these tables, which looks at VAT as a percentage of disposable income for non-retired households by quintile groups.

Bottom

2nd

3rd

4th

Top

All non-retired households

11.6

8.4

7.9

7.2

5.7

7.3

When all taxes are considered together, they account for 38.7% of the gross income of the bottom quintile of non-retired households, compared with 34.8% of the top quintile.

It is sometimes argued – for instance by the IFS, whose views should always be taken seriously – that low income is often temporary and it makes sense to look at indirect taxes as a percentage of expenditure.

I don’t agree. This approach leaves out of account the money higher-income groups allocate to savings and investments, an activity not usually open to the poor. Even if we do take that approach, the ONS analysis of VAT as a percentage of expenditure for non-retired households shows that VAT remains slightly regressive:

Bottom

2nd

3rd

4th

Top

All non-retired households

7.7

7.6

7.7

7.5

6.9

7.4

Even if VAT accounted for the same percentage of expenditure for the bottom quintile as the top, a shift from from a progressive tax like income tax to a not particularly progressive tax like VAT would still make the tax system overall less progressive.

That is why the pattern of changes to tax rates is so important. Shifting the balance from income tax to National Insurance Contributions has made the tax system somewhat less progressive, especially at the top end. The doubling of VAT rates in the 1980s and 90s was very regressive. The structure of the system is all the more important given the fact that, overall, the tax to GDP ratio (net taxes and National Insurance Contributions as a percentage of GDP) hasn’t changed much during this time:

Year

Tax-GDP ratio (%)

1978 to 97

33.1

1997 to 98

35.1

2010 to 11

34.6

Taxes are important for the debates about how to manage the deficit and promote growth, but they also have a vital impact on poverty and inequality; trades unionists should never forget that.

Written by Richard Exell

I am the TUC’s Senior Policy Officer covering social security, tax credits and labour market issues, including the debates about the European social model and labour market flexibility. I also represent the TUC on the Industrial Injuries Advisory C…